The dollar's recent rebound is paring the steep gains US investors made last year on foreign bond portfolios and may make them turn more towards US fixed-income securities in coming months, according to analysts.
For fixed-income fund managers who invest outside their domestic market, the performance of the currency in which those bonds are denominated can be key to how the investments fare.
Recent debt troubles in Dubai and Greece have underscored risk outside the United States, helping the dollar gain more than five per cent against a basket of currencies since late November.
Strengthening US economic data, meanwhile, has reinforced expectations the Federal Reserve may start raising interest rates before the European Central Bank, a prospect which could bolster the dollar for months to come.
"The market is starting to get ready for a potential change in short-term rates," said William Larkin, portfolio manager with Cabot Money Management in Boston. "That does have a pretty big impact on the dollar and a pretty big impact on foreign bonds."
Mr Larkin recently sold a position he held in the Templeton Global Income Fund which had gained about 30 per cent through the end of November, because a big slice of its gains came from the dollar's decline against other currencies, a move that has now reversed.
"A lot of the relative benefits of overseas investing has been currency-related and if you get a bounce in the dollar you remove some of that tailwind," said Lawrence Glazer, managing partner of Mayflower Advisors in Boston.
If the dollar trend continues, investors may favour US corporate bonds and Treasuries over foreign bonds this year, according to fund managers.
"People might be a bit less enthusiastic in investing overseas relative to the United States," said Mr Glazer, who himself is becoming more cautious about investing in foreign bonds.
"In the short run, US equities and fixed income might benefit on a relative basis," Mr Glazer said.
Judging by some recent flows data, investors have already started to make the switch.
Net inflows to US bond funds tracked by Emerging Portfolio Fund Research totalled $3.03 billion the week ending December 9, the fourth biggest inflow for 2009. But inflows to global bond funds dipped below $1 billion per week in early December, according to Brad Durham, a managing director of EPFR Global in Boston.
"It looks like investors probably are reacting to expectations of a strengthening or recovering dollar," Mr Durham said.
Even if the dollar doesn't gain much from here, some bond analysts recommend hedging foreign bond portfolios against currency gyrations.
The dollar will probably trade in a broad range against other currencies in early 2010, said Kevin Flanagan, fixed income strategist for global wealth management with Morgan Stanley in Purchase, New York.
"I wouldn't be looking to invest in non-dollar in a pure currency play because that won't necessarily offer the same opportunity it did in 2009," he said. To be sure, US investors in foreign bond funds could still tap currency gains this year if they invest in the debt of emerging markets whose currencies are rallying against the dollar, said Michael Collins, principal at Prudential Fixed Income Management in Newark, New Jersey.
Yet Mr Collins also warned of the risk to these foreign bond investments if the US economy grows a lot faster than expected, which should be bullish for the dollar over the near term.